Earning the right to grow: how capital efficiency drives TSR performance

Companies must improve return on investment before allocating capital for growth.

In brief

• Investors value growth but they also want to see that companies are efficient at earning returns from invested capital, a new EY-Parthenon study shows.
• Total shareholder return (TSR) depends on having high return on invested capital (ROIC) as well as growth, and companies must improve ROIC to earn the right to grow.
• Companies should assess if their ROIC is high or low and adopt a strategy to improve it before investing or invest carefully to maintain a high ROIC.

When faced with the question of improving TSR, most executives default to growth. New EY-Parthenon research shows that, as much as investors value growth, they want to see that companies can manage capital efficiently.

Our analysis approach

To get a deeper understanding of the relationship among growth, capital investment and TSR, we analyzed value creation for 360 companies in the S&P 500¹ using a proprietary, forecasted cash flow model. Our findings challenge conventional wisdom, revealing sharply different paths to positive TSR, depending on a company’s ROIC.

For the study, we divided the sample companies into high- and low-ROIC groups, based on average historical ROIC over a three-year period, 2021-2024, and then examined how each group fared with respect to TSR.

What we learned about TSR and ROIC

For companies with low ROIC, the priority should be on “earning the right to grow” by improving their ability to get the most value from their existing investments. Meanwhile, companies with high ROIC should prioritize deploying new capital at attractive returns.

The analysis results have profound lessons for companies in each of the resulting ROIC vs. TSR quadrants. And while the analysis is sophisticated, the lessons we learn mirror those from familiar fables.

Survey result quadrants, by ROIC and TSR

The tortoise and the hare: a health care example

When we zoom in at the sector level, this dichotomy of outcomes becomes evident.

The tortoise: For example, in the health care products distribution sector, leaders at two of the largest players recognized the importance of capital efficiency, given their high-volume and low-margin business models. After recent supply chain disruptions wreaked havoc on company balance sheets and ROIC, executives at both companies recognized that growth should not be their primary focus. Instead, they committed to repairing their balance sheets by returning working capital to normal levels. This prudent strategy was rewarded by shareholders, resulting in significant TSR.

The hare: In contrast, another company in the same sector continued to prioritize growth and invested in a series of acquisitions, which, like the company, had low ROIC. The acquisitions further damaged ROIC, sank investor confidence and reduced TSR.

Ants: investing, but thoughtfully

And what about the ROIC leaders? What should they do to maintain results? Companies that are fortunate to have high ROIC should invest for growth but must do so in a disciplined way, so they do not dilute their strong ROIC. The data show that companies in this category vary widely in their ability to do this.

Both high- and low-TSR performers — the ants and grasshoppers in our table — deployed more capital and grew sales. However, the ants did so by investing while also maintaining or enhancing capital efficiency and margins, thus earning greater investor confidence and growing TSR by 73%.

Grasshoppers: squandering advantages, losing value

The results for the low-TSR segment, the grasshoppers, show that the cost of getting it wrong is expensive. These companies deployed capital at high levels (84-point vs. 61-point contribution to TSR), but their declining ROIC negated the benefits by -74 points. Investors again lowered their expectations (a -20-point impact), finally resulting in a mere 10% TSR impact, compared with 73% for the better-performing ants. The companies thus wasted their high historical ROIC by investing inefficiently and moreover lost the confidence of their investors.

The ant and the grasshopper: a technology example

The ant: While one might expect highly capitalized technology firms to generate similar returns from their rapid expansion into AI investments, the reality is they are seeing a wide range of ROIC performance and value creation outcomes from comparable levels of investment in similar assets. For instance, one technology company’s nearly $100 billion investment in data centers has enabled it to scale its high-ROIC business, achieving a rate of return significantly higher than the cost of capital for building and acquiring these assets.

The grasshopper: In contrast, another technology giant experienced a lower return on similar capital investments, resulting in negligible changes in TSR.

Three steps companies can take

1. Understand ROIC.

First, leaders must determine if they have earned the right to grow by evaluating how effectively they are using their balance sheet, with ROIC as a key measure. The benchmark should be whether ROIC exceeds the cost of capital. Depending on where they land, using this measure, companies can choose one of two paths to success described above.

2. Be a tortoise or an ant.

Those with low ROIC should emulate the tortoises, focusing on improving capital efficiency and margins, by restructuring underperforming units, for example, or divesting non-core assets, or making operational improvements. When ROIC exceeds the cost of capital, they have earned the right to invest for growth.

Companies that already have a healthy balance sheet and high ROIC have more options but must be systematic, like the ant in our story, by making smart investment decisions that build future value and avoid squandering their advantage.

3. Tailor the approach.

Since most companies have a mix of low- and high-ROIC businesses, leaders should adopt a tailored approach, prioritizing investment in high-ROIC businesses to generate the highest returns and align with long-term goals. This could involve expanding into new markets, developing innovative products, or acquiring complementary businesses.